Hit the Fed’s Curveball


Kevin Gale, Managing Director, Head of Fixed Income

The yield curve is a line that plots interest rates (yields) of U.S. Treasury securities ranging from one month in maturity out to 30 years. The slope of the yield curve can help investors determine the outlook for the economy. Under ‘normal’ economic conditions, the yield curve is upward sloping, meaning short-term interest rates are lower than long-term rates. When the Federal Reserve starts to raise interest rates and investors become concerned about the future economic outlook, the yield curve can invert, meaning short-term interest rates are higher than long-term interest rates. As a result of this, investors tend to favor purchasing short-term bonds, simply because of their higher yield than longer-term bonds.

Historically, the inversion of the Treasury yield curve, as defined by the difference in yield between the 2- year Treasury note yield and the 10-year Treasury note yield, has lasted from very short time periods of one month or less, to longer time periods of nearly two years. On average, when the Treasury yield curve inverts, it lasts about 7 months before it resumes its traditional upwards slope (long-term yields become higher than short-term yields). The inability to exactly time these movements in yields and the associated reinvestment risk of shorter dated maturities, make it important for investors to consider if solely purchasing short-term bonds in a portfolio is the best approach for their fixed income needs.

As shown in the following chart, the yield curve has inverted numerous times since the mid-1970s. In general, on a historical basis, if you had purchased a two-year treasury note when the yield curve initially inverted, you would find yourself reinvesting upon maturity two years later at a lower yield, even if you buy a longer-dated security. This reinforces our view that a laddered bond portfolio is often the most diversified approach to bond investing over time.

U.S. Treasury Yields

U.S. Treasury Yields
Source: Bloomberg

In addition, historically, a diversified intermediate-term bond portfolio has outperformed a short-term bond portfolio over time, even during periods of inverted yield curves. The following table shows the total return of a diversified short-term bond index versus a diversified intermediate-term bond index over a two-year period from the time the yield curve first inverted. Only once since the late 1970s did the short-term bond index outperform.

Bond Market Cumulative Total Return

  Jan ‘06 – Jan ‘08 Jun. ‘06 – Jun. ‘08 Feb. ‘00 – Feb. ‘02 Aug. ‘89 – Aug. ‘91 Jan. ‘89 – Dec. ‘90 Jan. ‘82 – Dec. ‘83 Aug. ‘78 – Jul. ‘80
Bloomberg 1-3 Yr Govt./Credit Index 13.10% 12.65% 18.02% 21.15% 20.73% 32.07% 17.90%
Bloomberg Intermediate Govt./Credit Index 14.17% 13.89% 21.16% 21.90% 21.81% 36.08% 14.15%

Source: Bloomberg

Predicting where interest rates will be two years from now, much less ten years from now, is one of the most difficult tasks in investing. Over time, we believe maintaining a well-diversified intermediate duration, laddered bond portfolio provides investors with an excellent source of diversification from interest rate risk, which is one of the key risks to manage in fixed income investing.

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